Missing the point on the economic battle of the century

British journalist Nicholas Wapshott's new book, Keynes Hayek: The Clash That Defined Modern Economics is about a heated debate, eight decades past, between two of the most influential economists in modern history. That debate, which took place in the midst of the Great Depression, concerned the causes and cures of business cycle downturns.

The book comes out at a propitious time. The ongoing economic crisis raises many of the same questions that fueled the intellectual duel between the British-born liberal lion John Maynard Keynes and F.A. Hayek, his free market Austrian friend and opponent. The confluence between subject matter and current events surely helped Wapshott sell his book to a publisher and likely will sell many copies to readers. But potential buyers should be aware that the book says nothing about how the economic dispute between Keynes and Hayek might apply to today's economic situation. This omission proves fatal.

Wapshott does not ignore the present in favor of the distant past, although the bulk of the book's narrative is set in the 1930s. But he seems to think his subjects' contemporary relevance is best reduced to the big-picture conflict between government intervention (Keynes) and free markets (Hayek). Wapshott focuses on the disagreements the two had over political philosophy and practice rather than the technical specifics of their economics. Those political disagreements are important, but they arose from crucial differences in economic theory.

For example, Keynes believed that intelligent, well-meaning planners manipulating economic aggregates such as demand and employment can bring about a happy end to business cycles. Hayek, by contrast, insisted that individual decisions and imbalances between specific prices and demand, or interest rates and specific plans for long-term productive projects, are where the economic action is.

Modern Keynesians tend to sniff at the notion that their man and Hayek were equal participants in the "clash that defined modern economics." They note that Hayek did not wield a similarly huge influence on modern macroeconomics, and they are right in the sense that the Austrian questioned the value of macroeconomics as an intellectual project in the first place.

At its root the Keynes/Hayek clash concerned alternate theories about how business cycles work. Wapshott does a workmanlike job walking readers through the lectures, books, articles, reviews, rebuttals, and counter-rebuttals that made up the bulk of their dispute. That is the book's greatest value, and it's the most thorough and lengthy such discussion available in the lay literature.

Before the two men began feuding, Keynes was already a hero to the rising generation of economists at Cambridge, but his ideas were considered somewhat heretical by the dons of the London School of Economics. The LSE's Lionel Robbins imported Hayek, a monetary/business cycle theorist and disciple of Ludwig von Mises, to represent a counter-Keynesian perspective. (Robbins and Keynes had feuded as members of a government commission, where Robbins refused to sign on to Keynes' prescriptions for public works spending and tariffs as a solution to the Depression.) The Austrians thought free markets tended toward a workable equilibrium that reflected people's desires and choices; the new Keynesian ideas posited that free markets sometimes guided economies into ditches from which only concerted government action could pull them out.

This book is about nothing if not economic theory and history; the personalities simply aren't that gripping, despite slightly interesting scattered details about Hayek's marital troubles and the torrid affairs between Keynes' disciples. Yet Wapshott somehow never spends more than a sentence or two at a time on complicated economic ideas. He devotes far more space to discussing the feuding economists' intemperate tone than he does to explaining what they meant. Readers who don't already have a basic understanding of Hayekian and Keynesian economics will get little help here.

The book is riddled with errors of judgment, especially about Hayek's position. Wapshott thinks that Austrian theory is "mechanistic" and based on a belief that the "free market was virtuous." In fact, Hayek's notion was that markets were highly organic, especially compared to Keynes' vision of manipulating economies like machinery, and Hayek's Austrian perspective was studiedly and deliberately value-free in its economic analysis. While Austrians tend to think free markets redound to the greatest benefit of the greatest number, that conclusion arose from their scientific understanding of how the world worked, not a moral judgment about how it should be.

Wapshott thinks the Misesian critique of socialism was that prices "were made redundant," when what Mises actually said about socialism is that it made prices, and the information we get from prices, impossible. Wapshott thinks Hayek's understanding of the function served by prices was not about the spread and coordination of decentralized information and knowledge (which it was) but rather about freedom. At the end of the book, where you'd expect Hayek's economic views about business cycles to be central to the discussion, Wapshott forgets them entirely in favor of his politics.

But the Keynes/Hayek argument was more complex than just the political question of government vs. markets. It was about complicated notions of price adjustment, especially the vital question of price adjustments for labor. In a 1930s context of very powerful unions, Keynes thought it was politically impossible to achieve the nominal wage reductions necessary to clear the market for labor—that is, to let wages fall so that hiring would be cheaper and unemployment thereby reduced. He instead promoted inflation as a means to trick labor into taking lower real wages.

Wapshott seems to want us to take Keynes' side on this. He writes sentences like, "Keynes believed that the chronic unemployment endured by Britain and America in the 1920s and 1930s was evidence that the full employment equilibrium was a fallacy," without mentioning prices or wages. The point from Hayek's side is that no equilibrium is possible when prices don't or can't adjust. In neither country did wages—the price of labor—adjust downward in order to increase the demand for labor—that is, employment.

Unemployment was understandably one of the great battlegrounds of the Keynes/Hayek feud. In a business cycle bust, did unemployment have to be cured by government manipulation of aggregate demand—by spending any way, any how, as Keynes advocated? Keynes thought that if you have idle people and capital goods, you should get them working again by any means available, even if the projects prove inflationary or produce nothing that anyone wants (such as holes by the side of the road).

From Hayek's perspective, booms and busts were caused by unnatural credit creation, setting in motion productive processes (say, home building) that end up not paying off in the end, given people's real desire for future goods vs. present ones. Under normal circumstances, those desires would tend toward equilibrium via adjustments in interest rates. But interest rates are skewed by artificial credit creation. While the additional credit has short-term stimulative effects (booms), in the long run a structure of production that does not match actual saved capital will collapse, leading to damaging busts.

Keynes' most famous quip (although he said it before his Hayek fight and in a different context) applied to Hayek's worries about the long-run effects of inflationary attempts to put the consumption cart before the production horse. "In the long run," Keynes said, "we are all dead."

Hayek thought the long run might come quicker than Keynesians believed. In his 1941 book Pure Theory of Capital, the Austrian quoted Keynes' famous line, adding, "I fear that these believers in [that principle] may get what they have bargained for sooner than they wish." Hayekians would argue that our current economic crisis is an example of living in Keynes' "long run"—that inflationary credit expansion and high levels of government spending have led to a bust and a debt crisis that we can't handle. While Keynes himself thought government should spend borrowed money only during recessions, his disciples in government observe no such restriction.

Partly because he shifted from economics to political philosophy in the second half of his career, Hayek is often treated merely as a small-government polemicist. (Wapshott, trying to complicate this view, erroneously reports that Hayek believed in universal government-provided health care.) It's a shame that a book centered on the years of Hayek's greatest and most influential work as an economist only cements this incomplete reputation.

When the Royal Swedish Academy of Sciences awarded Hayek the 1974 Nobel Memorial Prize in Economic Sciences, it described his contributions this way: "His theory of business cycles and his conception of the effects of monetary and credit policies attracted attention and evoked animated discussion. He tried to penetrate more deeply into the business cycle mechanism than was usual at that time. Perhaps, partly due to this more profound analysis, he was one of the few economists who gave warning of the possibility of a major economic crisis before the great crash came in the autumn of 1929. Von Hayek showed how monetary expansion, accompanied by lending which exceeded the rate of voluntary saving, could lead to a misallocation of resources, particularly affecting the structure of capital."

These are precisely the aspects of Hayek's thought that make him relevant to the current crisis, and these are precisely the aspects that Wapshott avoids when discussing it. That lacuna makes his book a maddening missed opportunity for readers trying to understand how the hoary economic-journal arguments of the 1930s might shed light on today's problems.

The years leading up to our cur- rent crisis saw exactly the sort of artificially low interest rates and monetary expansion that Hayek warned would cause unsustainable booms and busts, in this case manifest in the housing market. In reaction to the 2001 recession, Federal Reserve policy became highly expansionist. M2, a major monetary aggregate measure, stayed above 8 percent through 2003. The Fed also strove to keep interest rates low to stimulate growth. The "federal funds" interest rate plunged from 6.75 percent to 1.75 percent in 2001, reached a record low of 1 percent in mid-2003, and stayed at that level for a year.

"The real Fed funds rate was negative…for two and a half years," economist Lawrence White wrote in a 2008 Cato Institute essay. "The Fed from early 2001 until late 2006 pushed the actual federal funds rate well below the estimated rate that would have been consistent with targeting a 2 percent inflation rate.…The excess credit thus created went heavily into real estate. From mid-2003 to mid-2007, while the dollar volume of final sales of goods and services was growing at a compounded rate of 5.9 percent per annum, real-estate loans at commercial banks were…growing at 12.26 percent."

That growth was artificial, and for various reasons having to do with federal housing policy and the practices of the financial industry it led to an economy unhealthily dependent on continually rising housing prices. As Hayek would have predicted, the bust was inevitable. And here we are.

This view is by no means the consensus among economists. Still, many economists outside Hayek's Austrian tradition—including monetarist Anna Schwartz, Keynesian Brad DeLong, and Treasury Secretary Tim Geithner—have at least partially blamed the boom and bust on the Federal Reserve's reckless credit expansion. But Wapshott doesn't even allude to the possible relevance of Hayek's business cycle theory to our present mess, whether to support it or debunk it. It's as if he does not understand the actual significance of his project.

Wapshott's book comes on the heels of two glossy video parodies that became Internet sensations by portraying the Keynes/Hayek conflict as a hip-hop battle. The makers of those videos, George Mason University economist Russ Roberts and online content developer John Papola, understood that the dispute was about something more specific than government vs. markets. It was about the boom and the bust, what causes business cycles and what might ameliorate them. In less than 20 minutes combined, those videos explain the contemporary significance of the Keynes/Hayek debate better than Wapshott's book. And they're a lot more fun as well.

Senior Editor Brian Doherty is the author of Radicals for Capitalism: A Freewheeling History of the Modern Libertarian Movement (PublicAffairs).

Editor's Note: We invite comments and request that they be civil and on-topic. We do not moderate or assume any responsibility for comments, which are owned by the readers who post them. Comments do not represent the views of Reason.com or Reason Foundation. We reserve the right to delete any comment for any reason at any time. Report abuses.

53 responses to “Keynes vs. Hayek, Oversimplified”

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Wapshott seems to want us to take Keynes’ side on this. He writes sentences like, “Keynes believed that the chronic unemployment endured by Britain and America in the 1920s and 1930s was evidence that the full employment equilibrium was a fallacy,” without mentioning prices or wages.

That’s because Wapshott assigns a moral component to employment or labor, that is: not something that should be commoditized and left to the devices of supply and demand. What people like Wapshott and others do not understand is that the true cost of something will ALWAYS, INVARIABLY, manifest itself in SOME way. With labor, the true cost of it will manifest itself in inordinately high unemployment levels if prices are not allowed to fall to clear the market. It will thus not matter just how high a pedestal they place under labor, it will ALWAYS BE a commodity whether they like it or not. If labor is exchanged for something else, labor is ipso facto a commodity.

Thats why inflation is their go to weapon when they get pushed into a corner. Inflation has the effect of causing labor prices to drop, while hiding that fact from those who are experiencing the drop in wages.

As an extra added bonus, the same people who advocate inflation as a cure all also claim to be the ones who care about the poor, despite the fact that their own policy advice hits the poor the hardest.

Yeah, because between being unemployed … and taking a pay-cut via inflation (ever heard of a thing called “downward stickiness” ?) … better to be unemployed.

There was inflation during the 30s and yet unemployment remained high. People are not fooled by the inflation game, Daniel. If you still do not allow prices to fall to the point the market clears, you will have unemployment no matter how high the inflation. This was more than proven during the Great Stagflation of the 70s, something the Keynesians said could not happen.

It boggles the mind just how much people will stake their reputations on the idea that drawing a circle in the sand around a bunch of people modifies or sets the parameters of economic activity.

Once can, of course, look at economic phenomenon on a greater scale than the individual transactions, like for instance the effect of the interest rate on the consumption vs investment paradigm, but from there to deduce that the activity of the bunch is totally different than the activity of the individual is like saying that gravity has an entirely different effect on the sun that it has on an atom, when in fact it doesn’t.

Can you imagine any model of an ecosystem that would attempt to reduce the complexity of that system to a few aggregates, and then think that manipulating those aggregates affected the ecosystem? – That’s macro economics.

It’s only value is as a useful rationalization for political spending.

But Wapshott doesn’t even allude to the possible relevance of Hayek’s business cycle theory to our present mess, whether to support it or debunk it. It’s as if he does not understand the actual significance of his project.

To sum up, Rothbard falsely accused neoclassical utility theory of assuming cardinality. It does not. There is nothing actually wrong with Rothbard’s value scale approach, but because the neoclassical assumptions are in some ways less restrictive than Rothbard’s[14], neoclassicals made the important discovery that price changes have both income and substitution effects – a discovery Rothbard was unable to derive from his own postulates but conceded without explanation.[15]

Resilience of demand in the face of artificial supply constraints supports Rothbard’s position.

What I [Brian Kaplan] deny is that the artificially stimulated investments have any tendency to become malinvestments. Supposedly, since the central bank’s inflation cannot continue indefinitely, it is eventually necessary to let interest rates rise back to the natural rate, which then reveals the underlying unprofitability of the artificially stimulated investments. The objection is simple: Given that interest rates are artificially and unsustainably low, why would any businessman make his profitability calculations based on the assumption that the low interest rates will prevail indefinitely?

Answer: He doesn’t. The average busienssman simply cannot KNOW how long the interest rates will be kept low, first. Second, the guy has to eat.

Kaplan totally ignores the role that Time Preference plays in the creation of malinvestments and their continuous fueling. He also ignores the influece of the Prisoner’s Dilemma in the businessman’s decision-making: Businesses WILL be confronted with a sudden increase in demand because of the cheaper credit, so what are they going to do – tell the customer to go fuck himself? The business has to reap the profits before someone else takes them.

Answer: He doesn’t. The average busienssman simply cannot KNOW how long the interest rates will be kept low, first. Second, the guy has to eat.

Kaplan totally ignores the role that Time Preference plays in the creation of malinvestments and their continuous fueling. He also ignores the influece of the Prisoner’s Dilemma in the businessman’s decision-making: Businesses WILL be confronted with a sudden increase in demand because of the cheaper credit, so what are they going to do – tell the customer to go fuck himself? The business has to reap the profits before someone else takes them.

Ultimately, Kaplan’s position requires omniscience on the part of entrepreneurs.

but nevertheless Rothbard draws demand curves showing the quantity desired at all possible prices. Similarly, one can only observe that I choose a green sweater; but this does not rule out the possibility that I was actually indifferent between the green sweater and the blue sweater.

Mises and Rothbard have a final related objection to standard neoclassical utility theory: the assumption of continuity. Quoting Rothbard, “[H]uman beings act on the basis of things that are relevant to their action. The human being cannot see the infinitely small step; it therefore has no meaning to him and no relevance to his action.”[16] The implications are broader than they may initially appear, because as a mathematician will tell you, you can’t differentiate a function that isn’t continuous. This means that if Mises and Rothbard is correct, the pervasive use of calculus in economics must be rejected in toto.

One obvious problem arises here. Without continuous preferences, it is also highly unlikely that e.g. supply and demand can ever be equal. If you draw the supply and demand curves continuously, then they are (almost) bound to intersect. But if you draw them as a discrete set of points, supply and demand in general don’t have to intersect. Thus, the argument against calculus based upon the rejection of continuity also argues against even the use of simple algebraic constructs – like intersecting supply and demand lines – that fill Rothbard’s works.

This position of Rothbard’s is validated by marketing efforts that leverage a small change in price to affect a greater purchase.

If Rothbard was incorrect, that would be impossible. The fact that it is a standard part of pricing and marketing strategies by real world businesses supports Rothbard’s position.

The author seems to be arguing against the fact that government spending provides concentrated benefits with diffuse costs (the seen and unseen) or that it is somehow worthwhile because the right people psychologically benefit.

However, current events do nothing to show that economic calculation was the insuperable difficulty of socialist economies. There is no natural experiment of a socialist economy that suffered solely from its lack of economic calculation. Thus, economic history as well as pure economic theory fails to establish that the economic calculation problem was a severe challenge for socialism.

This is the author sticking his fingers in his ears, closing his eyes and shouting Socialism can work, history proves nothing, we just need the right people in charge….

Gee Danny, you’re so smart! I’ll bet that the Keynesians you admire must have been right on the ball predicting the economic disaster unfolding all around us, while those Austrian troglodytes were caught flat-footed, right?

Oh wait! I just remembered, the Austrians have been right all along, and your faction has been left slack-jawed yelling for more and more taxing, spending and debt!

It’s not “emotionally appealing,” Daniel. Austrian economics are logically consistent and cogent. Instead, Keynesians present an implicit emotional appeal when prescribing inflation as a way to “fool” workers into believing their wages were not really falling.

The problem is, Wapshott gets Hayek’s macroeconomics wrong — Hayek’s macro is grounded in monetary economics, and Wapshott is completely ignorant of the core of Hayek, and it gets left out.

And after reading & learning Milton Friedman’s report of the actual monetary numbers of the Depression, on the basis of this new information Hayek completely changed his assessment of what went wrong in America in the post-bust phase of the Great Depression — Hayek OPPOSED allowing a secondary deflation, and advocated what the ignorant might regard as “Keynesian” measures to block it.

Hayek also changed his mind about Britain in the 1925-1933 period. Hayek ALWAYS saw the British deflation as completely pathological, but after years of the effort, thought it dumb not to reap the gains which were almost achieved. But Hayek later said he miscalculated the possibility of breaking British union power and lowering overpriced British wages — meaning that the pathological British deflation policy was going to take far longer than Hayek anticipated.

Wapshott is ignorant of all of this history — his research is paper thin and doesn’t go beyond it seems two Hayek books, out of several dozen.

[…]after reading & learning Milton Friedman’s report of the actual monetary numbers of the Depression, on the basis of this new information Hayek completely changed his assessment of what went wrong in America in the post-bust phase of the Great Depression — Hayek OPPOSED allowing a secondary deflation, and advocated what the ignorant might regard as “Keynesian” measures to block it.

The problem was that Friedman’s report arrived at the wrong conclusion, because he ignored the previous inflationary process of the Federal Reserve which lead to the bust of 1929-1930. Friedman simply assumed that the correction was the cause of the Depression.

Friedman totally ignored the deflationary process of 1919-1921 when the economy was correcting for the inflation of the war years. However, whereas the deflationary process of 1919-1921 did NOT lead to a greater depresion (quite the contrary), the bust and correction of 1929-1930 dragged on and became worse all the way to 1945, after FDR’s timely death. Friedman did not wonder about this and, instead, focused on the wrong “cause.”

If it is true that Hayek reconsidered his stance on deflation, then Hayek was wrong. But I have a feeling he did not embrace an anti-deflationist stance – you will have to link to that.

“Wapshott thinks that Austrian theory is “mechanistic” and based on a belief that the “free market was virtuous.” In fact, Hayek’s notion was that markets were highly organic, especially compared to Keynes’ vision of manipulating economies like machinery”

I haven’t read the book, but if this characteristic is correct, Wopshott fails to grasp one of the key differences between Hayek and Keynes.

To see how mechanistic Keynes’ disciples viewed the economy, consider the Moniac computer.

A government that followed any disciplined and disinterested economic theory would be better than the status quo. Whether it is counter-cyclical tax-and-spend policy by Keynes or something more rigid by the Austrians, we would have a predictable and stable path. Instead, what we get is pro-cyclical give-aways when the economy is good, and pro-cyclical austerity when the economy goes down — which accords with no economic theory whatsoever.

It’s a pity that Hayek — who had been a Georgist for a while, and said a few polite words about Georgism in The Constitution of Liberty, while concluding that it was unworkable — didn’t understand the importance of land in a modern economy. We’ve just had a lesson in that, or at least we should have learned one. Low interest rates led to high real estate prices — but why? Imagine a plot of land with an annual ground rent of $1000. At 10% interest, it sells for $10,000. At 5% interest, it sells for $20,000. At 1% interest, it sells for $100,000, and if effective interst rates are zero or negative, its price goes to infinity.

That’s what happened to the real estate market in the years leading up to 2007, and Dr. Fred Foldvary predicted the recession several years in advance using his Austrian/Georgist synthesis.

Reason.com and most of the people who post comments here are continually pointing to market distortions made by helping poor ? minimum wages, social safety net – but there is piss little about the market distortions created by the capitalist. You know things like price collusion, functional monopolies, etc And nothing about the fact that the basis of both these economics theory depends on the fanciful creature called a “rational actor” what economics doesn’t understand about the human animal and what drives us to make choices constitutes a vast chasm. Marketers understand it much better than economists. Economist say we make choices based on comparing price and utility, sometimes maybe, but a lot of our choices are made on much more basic dare I say “instinctive” impulses such as social status, or trying to fill that miserable unfulfilled hole left by ever more soulless factory and service jobs. You have these great math formulas for supply and demand and view prices as this natural law when for most of human history we lived in very egalitarian hunter gatherer societies whose main economic process was the “big man” giving away as much stuff as he could. We became the most adaptive creature on this earth not by living as individual labor competitors but by being social cooperative animals that help each other. In your system it’s ok for an employer to find the most desperately poor people in the world and take advantage of their desperation to set labor prices lower ? its just the mathematical fact of the natural order of things your above arguments seem to say ? after all, I’ve heard many of this ilk argue, they were starving, now they can feed themselves by working 80/hrs a week in horrid conditions to make our phones, tvs, and shoes. But by that logic if I come across a dying man in the desert and make him lick my shoes clean before giving him a glass of water well then I’m just a savvy member of a “free” market following the rules of nature as outlined by your philosophy, well as the man said there are things in heaven and earth not dreamt of in your philosophy. You deride inserting morality into economics; it’s a distortion of your law-of-the-jungle hard core reality, a softness that we will all have to pay for in the future. But humans are moral creatures, its been shown that humans without the emotional part of their brains can’t make decisions, they go through all the logical pros and cons endlessly, because they have lost all sense of value. Well my friends so have you. Humans are not just units of labor, and if you exploit their desperation to enrich yourself, it is evil, despite what your supply and demand curve may say.

You know …nothing about the fact that the basis of both these economics theory depends on the fanciful creature called a “rational actor” The explanation for the superiority of markets by those at Reason never comes from the idea of the “rational actor”. It comes from the idea of the “knowledge problem”, or an argument about natural rights. I have seriously never heard anyone here say that market actors are omnisciently rational. Bounded rationality, yes. But that is not what you are talking about here. The rest of your argument doesn’t really make enough sense to rebut because you are just making emotional appeals based on cherry-picked stories. You also seem to think that if government coercion does something, then the good done outweighs the bad, but if a (relatively) freer market does something, then no amount of good can compensate for any bad done.

I tend to examine what the actual outcomes are of government policies, not just the supposed altruistic intention. I’d rather thrive, supported by the efforts of those acting selfishly, than starve for the sake of your supposed altruistic intentions. And imaginary accounts of randomly running into dying people in deserts doesn’t change the statistical evidence that shows that free markets are what serve humanity the best.